Super funds: an investment vehicle for scientific research?

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Kevin Davis does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.

Can the growing stash of super savings be used productively to fund valuable bio-science and other R&D while still generating good returns for fund members?

Such research is typically high risk, but Professor Andrew Lo and colleagues from MIT think that financial engineering techniques can be used to create an investment vehicle suitable for super fund investment in such socially valuable research. Their research was published in Nature Biotechnology, October 2012.

The “trick” is the creation of a mega-fund, which invests in a large, diversified, portfolio of early stage research programs that have commercialisation potential. While each is individually high risk, the portfolio has significantly lower risk, enabling a securitisation model to be structured to attract funds from both risk averse and risk-seeking investors.

For super funds, the appeal should be twofold. First, financing investments that can ultimately improve the health of society aligns with their role of serving members.
Second, this would be a new asset class, with a return-risk profile quite different to other asset classes, but with adequate expected returns for the risk involved.

How big a fund is required? Professor Lo and colleagues estimate, based on historical data, that more than $5 billion is needed to obtain the required diversification benefits. Clearly, this implies that industry cooperation would be needed to establish such a fund. And some form of government contribution and investment (perhaps via the Future Fund) might be warranted to induce greater private sector funding of important research.

Is financial alchemy required to turn high-risk individual research projects into a feasible investment vehicle for super funds and other risk averse investors? No: a fairly straightforward form of securitisation is the answer. Sufficient scale and diversification leads to a future stream of returns on investments for the fund which has sufficiently low risk to enable the issue of a range of securities from highly rated senior bonds (which they term “research-backed obligations” through to more risky equity.

Where do the returns on the fund come from? Cash flows from selling promising research projects to later stage investors, sale of patents, or sale of rights to production of tested and approved drugs etc to pharmaceutical companies for commercialisation provide the returns. The fund is assumed to be wound up after about 7-8 years.

Professor Lo and his team estimate, on the basis of historical data and simulations, that senior debt could be issued paying 5% p.a. with a default risk of 0.01% which would put them in (or near) the AAA category. Equity investors (providing about one-third of total financing) would have an expected return of around 9%.

These estimates naturally depend on how the vehicle is structured, good investment decisions which generate returns similar to those observed historically, and the “waterfall” of cash flows from the investments are allocated. A government guarantee of the most senior debt tranches — to increase their appeal to investors — could be considered. This proposal probably has more merit than government guarantees of mortgage backed securitisations, which are frequently proposed).

While there is much scepticism about the merits of financial engineering following the global financial crisis, we saw in Australia that standard securitisation techniques were
robust, and their beneficial effects on the market for housing finance are well known.

Applying similar techniques to early stage bio-science funding could similarly develop the research funding and commercialisation market.

Of course, robust governance arrangements and scientific expertise are needed as well as financial engineering skills to ensure that good research projects are funded and
appropriately monitored, and that excessive complexity does not become a feature of the financial arrangements.

Five billion is a lot of money, but much less than 1% of superannuation assets. It probably exceeds worthwhile investable Australian research capacity in bio-science,
even when allocated over several years, but there is no reason that such a mega-fund’s investments could not be broadened to cover a wider field of R&D.

Super funds should be interested in examining this further. Government should be interested if such a proposal can increase private sector funding of research and leverage
public money allocated to research. University Vice-Chancellors should be interested. It warrants the investment of some time and funding to assess feasibility in the Australian context.